Indonesia's economy at a crossroads

With the passing of the presidential baton from Susilo Bambang Yudhoyono to Joko Widodo just a month away, Indonesia is at a political crossroad, with the first clear break from the politicians who were part of the Soeharto years. Monday's Indonesia mini-update at the Lowy Institute, a half-day version of the Australian National University's annual analysis of Indonesian politics, economics and social developments, revealed an economy also at a transition point.

The easy years of the commodity boom are over. Growth was a respectable 5-6% throughout SBY's decade, and the macro-economics were well managed. But growth has now slipped below 5% and the global economic environment is unhelpful.

SBY's second presidential term achieved much less than the optimists had hoped. Petroleum subsidies (affecting not only fuel but also electricity) still count for over a fifth of budget expenditures. These, together with the large financial transfers to regional governments, leave the national budget with no room to manoeuvre. There has been painfully slow progress in addressing the backlog of needed infrastructure projects. Sharp increases in labour costs in the formal sector are making Indonesia's large-scale manufacturing uncompetitive. Corruption remains endemic. Income maldistribution has worsened appreciably.

The president-elect brings corruption-free credentials and a successful administrative record, albeit at the sub-national level. The incoming vice-president is experienced and energetic. But the election campaign gave extra momentum to nationalist economic sentiments which are never far below the surface in a country where memories of foreign colonial exploitation still linger. Measures to force greater domestic processing of ore exports are gradually being sorted out at a practical level, but some damage lingers to Indonesia's reputation as a welcoming host of foreign investment.

A better assessment of the prospects will be possible when Jokowi picks his ministerial team. So far he has skillfully side-stepped pressure from the nationalist PDI-P, the political party he is associated with, to appoint party cronies with their baggage of dirigist economics. But Jokowi's own philosophy has not yet been clearly articulated.

All this is playing out in a global economy full of gloom, especially regarding the prospects of emerging economies. Indonesia did successfully handle the 'taper tantrum' in the middle of last year, when global markets over-reacted to the prospect of America unwinding its quantitative easing. Indonesia came through substantially better than other members of the 'Fragile Five' (India, Brazil, South Africa and Turkey) identified by financial markets to be at greatest risk. But markets remain nervous and Indonesian government bond yields remain well above those of countries like the Philippines, whose bonds were previously ranked alongside Indonesia's.

If the going does get tougher, Indonesia is poorly placed to handle a more serious crisis, either at the global level or domestically. As a still heartfelt legacy of the 1997-8 crisis, Indonesian policy-makers would be reluctant to seek help from the IMF. The operational effectiveness of the Chiang Mai Multilateral Initiative is extremely doubtful. Domestically, the Financial Sector Safety Net bill was rejected by parliament in 2008 and has little prospect of early revival, leaving policy-makers with few options in the event of financial-sector problems.

An experienced commentator at the mini-update likened the current situation to the early 1980s, when a commodity boom was ending and Indonesia required strong structural reform to set the economy on a less resource-dependent development path. At that time, policy-makers rose to the challenge, introducing growth-enhancing reform measures.

Jokowi operates in a far more difficult political environment compared with the 1980s. Will Indonesia, without the easy boost of spectacular commodity prices, squib the necessary structural changes and slip into the much discussed middle-income trap? Or will it reprise the restructuring of the 1980s, which could put it back on the 7% growth rates which characterised the Soeharto years? This is Jokowi's economic challenge.

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